aversion – YOU And YOUR MONEY®http://money.ca/you_and_your_money
Canadian financial writers on personal finance.Thu, 08 Dec 2016 06:30:53 +0000en-UShourly1https://wordpress.org/?v=4.5.4Don’t get whipsawed by Risk Management!http://money.ca/you_and_your_money/2013/05/28/dont-get-whipsawed-by-risk-management/
Tue, 28 May 2013 16:08:15 +0000http://money.ca/you_and_your_money/?p=3252Back in February of 2012, I recall a prominent CFO departing a global insurance company. This particular individual was labelled “the highly regarded architect of a hedging strategy that proved key in rebuilding investor confidence in the wake of the financial crisis.” The company had suffered financially during the prior market meltdown because of a huge exposure to equity-linked products; pre-crisis the company had introduced investment products that guaranteed to return a substantial (if not all) amount of the investor’s initial investment. The money was invested in the company’s funds which in turn invested in stock markets. During the financial crisis, the value of these assets (stocks) held in the funds declined below the amount that was guaranteed spelling serious trouble for the company. In response a stricter approach to risk management was adopted after-the-fact.

Sounds sensible doesn’t it? But it just isn’t! I’ve watched this pattern time and again over decades. The fundamental flaw is a complete misunderstanding of what constitutes risk.

Risk is almost always equated to volatility. For example, stocks move up and down rapidly with much magnitude so they are deemed more risky than bonds. But are we really as averse to upside risk as downside risk? Strangely people become more averse to volatility when they’ve suffered downside risk (and come to adore volatility when upside risk has rewarded them). Because our internal model of risk is so much more complex than mathematics can reckon with, our efforts to ‘manage’ volatility can actually subject us to less volatility but more risk. When we reduce risk (hedging strategies usually reduce volatility – both up and down) at the wrong times, we miss the chance to be rewarded by the kind of volatility we adore. We are our own worst enemies.

The President and CEO of a completely different insurance company was quoted as saying this, also in February of 2012:

“We are maintaining our equity hedges as we remain very concerned about the economic outlook over the next few years. We continue to be soundly financed with year-end cash and marketable securities at the holding company of about $1 billion.”

This statement followed the company’s earnings release, having reported substantially increased losses from its investments – management had hedged the company’s equity position in 2010 (again, after-the-fact) and suffered investment losses in that year’s fourth-quarter because stock markets rose (instead of declining). The actions designed to protect the company against volatility lost money. Risk aversion after-the-fact caused the company to lose money and avoid potential returns from upside volatility.

Because the pain caused by the downside volatility suffered previously was still fairly recent, aversion remained at a high level causing the company to stick to its hedging strategy (in denial?) despite these huge losses, and it continued to lose money as the market continued to go higher and higher still.

The financial crisis is behind us and now that markets are hitting all-time highs, record amounts of dollars are scrambling to get some upside volatility action. Too late? It’s hard to put a pin in it, but intuitively might one conclude that if managing risk (or ‘risk off’ as they say on business television) was a bad idea during and immediately after the financial crisis, then perhaps chasing volatility (‘risk on’) might not be such a good idea at present?

It might seem as if I was picking on insurance companies earlier, but many pension funds, other financial services companies, portfolio managers and everyday investors follow the same destructive pattern. Adoring upside risk but loathing downside risk – always at the wrong times – has ruined careers and put a serious dent in the life-savings of families. More experienced money managers (there are fewer of us nowadays) increase risk when others are most averse to the idea, and begin to manage risk (hedging, raising cash balances) during periods of ‘irrational exuberance.’ They’ve learned the hard way that it’s easier to keep all the hair on your head if you avoid circumstances that make you want to pull it all out.